Jul 7

S&P Gets a Wake Up Call, as the Conflict of Interest ‘Chickens’ Come Home to Roost

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Today Standard & Poor’s said it placed 612 classes of residential mortgage-backed securities backed by subprime collateral on CreditWatch with negative implications.  Although this affected only about 2% of the total outstanding RMBS rated by S&P from the fourth quarter of 2005 to the fourth quarter of 2006, it still is a significant issue.  S&P says that poor collateral performance, higher-than-expected loss trends, decreased credit support and changes in future rating methodology are all reasons behind this action.  Tranches affected range in credit rating from A+ to BB.  Importantly, the bulk of the RMBS market is AAA or AA.

However, I wonder if this wake up call by S&P is really being caused by the conflict of interest ‘chickens’ now coming home to roost.

Although every rating agency has the obligation as well as the right to change credit ratings due to deteriorating trends in a security or its collateral, one must take a more jaundiced look at revisions due to methodology changes.  The models used to rate subprime collateral and related tranches are basically an open book available to any issuer to “game” as they see fit.  One must wonder how much issuers knew about a given RMBS versus what the rating agencies knew via their standard models.  Now those models are being changed but, they still remain open to issuers and the potential for more gaming by issuers remains.

This brings up the issue of legal as well as reputational risk not only of the rating agencies, but of the investment bank issuers and mortgage brokers.  When all of the players in the mortgage market are incented to issue debt; all of the players will find ways to meet production goals…even if that means producing problems for investors down the road.  This, of course, sets up a deep conflict of interest between what your friendly broker/dealer is telling you about a security and what the reality is.

Related to this is the conflict of interest on the pricing of these subprime mortgages.  Broker/dealers who act as prime brokers for HF’s, as well as broker/dealers who finance portfolios of HFs, as well as the HFs themselves all have a similar interest….generally keep pricing high, unless there is evidence to the contrary, like a liquid market.  However subprime mortgages and several other relatively illiquid asset classes are not priced in a liquid market.  They are priced based upon some ‘matrix pricing’ variation and this approach will now be further complicated by S&P’s rating methodology change.

With a more conservative approach imbedded in the rating agency models, we can expect further downward pressure on subpime ‘matrix’ pricing, even if the bond has not been noted as downgraded in the agency press releases.

However let’s not just focus on subprime mortgages.  A similar conflict of interest is readily apparent in Leveraged Buyouts (LBOs).  In that case, private equity players look for advantageous financing and covenants.  Banks, realizing that they will not have to maintain the credit on their books, are more than obliging to provide financing and subsequently layoff credit risk in the CDS market (credit default swaps).

However the credit risks of mortgages, as well as corporate debt all need to find a home.  They cannot simply be continually traded amongst hedge funds and other “mark to market” (MTM) oriented investors.  Thus the best spot for these credit oriented instruments to find a home would be with investors who are not required to mark portfolios to market, but can instead be long term investors not subject to the short-term vagaries of market pricing.  Perhaps the best and most liquid source of such funds are found at many insurance companies.

S&P made a wake-up call on subprime deals and Moody’s and Fitch will undoubtedly follow (note: later in the day, Moody’s downgraded nearly 400 tranches).  There is, of course, the risk that the agencies will now try to out do each other in the downgrading game.

But the real issue is how the warehousing of credit risk at long-term investors not subject to mark to market will eventually play out.  So far so good, but news like this from the rating agencies should get insurers to take a long hard look at levels of credit risk embedded within the portfolio….both immediately and potentially apparent.